Week 8 - The Stock Market

Week 8: The Stock Market - FIN 1101 Introduction to Finance

Learning Outcomes

  • Understand various types of stocks:

    • Common stock

    • Preferred stock

  • Grasp key valuation models:

    • Discounted cash flow model

    • Constant dividend growth model

    • Price/Earnings (P/E) ratio valuation model

  • Distinguish between the primary and secondary stock markets.

Ordinary and Preferred Stocks

What are Stocks/Shares?

  • Definition: Stocks or shares represent ownership in the equity capital of a firm, allowing shareholders to share in profits and losses.

  • Types of Shares:

    • Common (Ordinary) Shares: Provide voting rights, dividends not fixed, last to be paid during liquidation.

    • Preferred Shares: No voting rights, fixed dividends, prioritized over common stocks during liquidation.

Characteristics of Shares

Ordinary Shares

  • Voting Rights: Shareholders can vote on management and key company decisions.

  • Dividends: Not fixed; can be unlimited based on profitability.

  • Payment Order: Paid after preferred shares and are last in line during bankruptcy.

Preferred Shares

  • Voting Rights: None.

  • Dividends: Fixed rate; typically paid before ordinary shareholders.

  • Priority: Higher than common stocks but lower than debt holders in liquidation.

  • Hybrid Nature: Combines elements of equity and debt, categorized as less risky than common stocks.

  • Cumulative Feature: Unpaid dividends must be paid before common stock dividends.

Dividend Policy

Definition

  • Dividend Policy: Refers to how a company decides to distribute profits to its shareholders versus retaining them for growth.

  • Retention Ratio: The percentage of profits retained.

Factors Affecting Dividend Policy

  • Liquidity: Availability of cash to pay dividends.

  • Volatility of Cashflow: Companies with unstable cash flows may retain more cash.

  • Debt Obligations: Contracts may restrict dividend payments.

  • Legal Restrictions: Regulatory limitations affecting distributions (e.g., REITs).

  • Business Cycle: Growing firms retain earnings; mature firms often pay dividends.

  • Shareholder Expectations: Adjustments may be made to align with shareholder needs.

Types of Dividend Policies

  • Stable Dividend Policy: Consistent dividend payments regardless of annual profits.

  • Constant Dividend Policy: A fixed percentage of profits paid as dividends.

  • Residual/Irregular Dividend Policy: Dividends are paid only after covering investment expenses.

  • No Dividend Policy: No dividends paid; common in growing firms.

Dividend Payout

  • Mechanism: Dividends are paid on a per-share basis, independent of share market value.

  • Example: Owning 10,000 shares with a dividend payout of RM0.50 results in a dividend of RM5,000.

Returns on Shares

Components

  • Dividends: Payments made to shareholders.

  • Capital Appreciation: Increase in share price.

Calculation Example

  • Owning 10 shares at RM10 each, receiving RM0.50/share, and selling at RM12/share results in total returns from dividends and appreciation.

Advantages/Disadvantages of Stocks

Advantages to Issuing Stocks

  • No obligation for dividend payments if profits are strained.

  • No requirement to repay capital unlike loans, reducing financial risk.

Disadvantages to Issuing Stocks

  • Shareholders typically seek higher returns than bondholders.

  • Increasing ownership dilution due to voting rights distributed to common shareholders.

  • Dividends are not tax deductible, making stock issuance costlier than loans.

Discounted Cash Flow Model

Common Stock vs Bond

  • Valuation Principle: Common stock is valued based on the present value of expected future cash flows, which are not fixed.

Valuation Steps for Common Stock

  1. Estimate future cash flows (CFs).

  2. Assess the risk associated with future dividends and determine the required rate of return.

  3. Calculate the present value of expected dividends.

Constant Dividend Growth Rate Model

Valuation Method

  • The model assumes constant annual growth in dividends:

    • Formula: [ Vcs = \frac{D1}{\text{rcs} - g} ]

    • Where:

      • ( D1 ) = expected dividend at the end of year 1

      • ( g ) = growth rate

      • ( rcs ) = required rate of return

Example Calculation

  • Assessing value when dividends grow at a fixed rate while analyzing the effects of varying rates on stock prices.

P/E Ratio Valuation Model

Definition and Use

  • P/E Ratio: A measure that indicates how much investors are willing to pay per dollar of earnings.

  • Formula: [ ext{P/E Ratio} = \frac{\text{Value of a stock}}{\text{Earnings per share}} ]

Implications of P/E Ratios

  • High P/E: Possible high growth expectations or potential overpricing.

  • Low P/E: Could indicate deteriorating earnings expectations or underpricing.

Stock Market Structure

Primary and Secondary Markets

  • Primary Market: Where new securities are issued and sold directly to investors.

  • Secondary Market: Existing securities are traded among investors.

  • Types of Secondary Markets: Organized exchanges vs. Over-the-counter markets.

Major Exchanges

  • NYSE: The oldest and largest stock exchange with strict listing requirements.

  • AMEX: Second largest but minimal volume compared to NYSE.

  • NASDAQ: First electronic stock market with a wider range of listed companies.

Summary

  • Key topics covered include types of stocks, dividend policies, valuation methods, and market structures, fostering a comprehensive understanding of the stock market.